The end of a perfect storm
The last few years have seen a “perfect storm” for active managers of global equities according to Charles Price, a manager in the global and international equities team at Schroders. As global equities represent probably the single largest source of new mandates, certainly in the European institutional marketplace, it is not surprising that the Russell Investment Group, undertaking manager research and running multi-manager funds, has seen a “substantial increase in the number of products over the past 10 years - with 21 products now on our buy-list versus five ten years ago” according to Phil Hoffman, responsible for global equities at Russell, explaining that its “current universe size is 140 institutional global equity products versus 50 five years ago”.
With a small cap effect, a value effect, and an emerging markets effect all having contributed to outperformance in a rising global equity market, it can be difficult to separate real skill from fortuitous positioning.
“Any manager overweighting these factors with a portfolio with a beta greater than one should have seen substantial continuous outperformance to such an extent that even sophisticated investors may see this as the norm,” explains Schroder’s Price.
However, he cautions: “Potentially there are going to be a lot of disappointments for investors who see anywhere up to 4% outperformance as reproducible indefinitely in the years ahead.”
This is a view echoed by Dave Iben, CIO of Tradewinds, a US global equity manager, who argues that “the past seven years have been good for small caps and mid caps, emerging markets and cyclicals, but the future will not be as good as the past”.
Dominic Rossi of Threadneedle Investments believes by contrast that “equities offer the highest
Sharpe ratio of all the major asset classes because the volatility has been so low during the last few years.”
He forecasts double-digit returns ahead as “equities as an asset class have a low valuation, particularly against bonds, which is why we are seeing M&A activity across all sectors driven by corporate activity and private equity”.
Most commentators would argue that global equity markets are unlikely to show double-digit
returns over the next few years. David Shairp, global strategist at JPMorgan Asset Management, for example, explains that the firm’s own work, which takes a global stock/bond risk premium approach, suggests that stocks are probably neutrally valued relative to bonds.
“While the risk premium of 4.8% is in line with the average of the past 10 years, it is slightly below that of the past five years. The central case outlook for equities argues for single-digit earnings growth, with limited prospects for valuation re-rating outside the US. Given current dividend yields, this suggests total returns for global equities of about 7-8%,” he says.
Simon Davis, the CIO for international equities at Putnam, also sees single digit returns for the next few years. “We have been through a period of exceptional returns,” he argues. “Equities look cheap relative to other asset classes but we need to have a view as to how long interest rates will remain so low. We have seen extremely high levels of profitability in cyclical industries but on a normalised historical basis, they look average.” Certain markets may do better: “We will get high single to low double digit returns in some emerging markets, with Korea, for example, looking cheap,”
Davis adds: “Continental Europe also has value as it is still in recovery mode with lots of M&A.”
Threadneedle’s Rossi argues that the US market “although not expensive, still sells at a premium to other world markets based on the GDP growth in the economy and the
return on equity.”
However, he wonders if this premium is justified: “During the 1990s, the US significantly outperformed the rest of the world and had a premium valuation because its return on equity (ROE) was higher than the rest of the world [but] now Europe and emerging markets have higher ROEs and it is only Japan that lags. So the case for the US valuation premium has gone.”
Aberdeen’s Bruce Stout is also negative on the US. “It is a struggle to find decent valuations in the US. It has been the worst-performing market for the last four years. It has been derated, but not enough,” he says. “It is the same in the UK. The UK is seeing so many takeover premiums, driven by M&A, with the private equity firms driving a lot of it, so valuations are higher than they would be on fundamentals.”
Stout adds that his house sees a lot of interesting valuations in Europe. “We see some very strong capital disciplines in European corporates even though the underlying growth is low. There are low expectations of growth, which means that the share prices do well when companies are managed efficiently.”
Stout adds there are lots of opportunities in Japan. “There are companies with 25-30% of the market cap represented by cash on the balance sheet. Japan has had the highest rate of dividend growth in the last two years. There is plenty of scope for dividend growth. The pay-out ratio is only 20%, and as bond yields go up to 2-3% it is not unreasonable to see 2.5-3% dividend yields in equities,” he says.”
More generally, Asia is interesting in terms of opportunities. Dividends are growing. If you have something with a decent dividend yield, the downside is protected and the upside will look after itself.”
While demand for global mandates appears to be generally increasing, this is not the case for all managers. Robeco for example, according to Mark Glazener, has found that demand is good for its global equities product, but less than earlier years “because there is a preference for regional mandates”.
However, investors suggest there is much to be gained by giving managers as few restrictions as possible when investing. This is driving them towards awarding global equity mandates, although the home bias is clearly seen in the prevalence of global ex-UK or global ex-Japan mandates that are awarded.
Even in the US, Todd Henry from T Rowe Price in Baltimore has found that there is surprising and significant demand for global equity mandates, a change from the traditional US plus EAFE approach. “An increasing number of plans are taking some money away from their US equity and EAFE equity mandates to fund a global mandate,” he says. “We have seen three to four global equity fundings from large corporate and public pension plans over the past year.
“Investors in the US increasingly believe that a globally integrated approach has the potential to offer additional alpha than what is achievable through the separation of their US and EAFE equity exposures. Finding a global equity approach that is truly integrated and not a bolt-together seems to be the key.”
The influx of new players has led to some significant changes in the supply of global equity investment products.
As Russell’s Hoffman explains: “Many of the new products tend to be unconstrained, higher alpha products and there are also more boutique managers focusing on fewer products.” Firms such as Nordea and Schroders have responded by creating more concentrated high alpha versions of global equity products as Nordea did four years ago.
Quantitative techniques have also had a profound impact and Hoffman finds that the most products today make some use of quantitative techniques versus a minority 10 years ago, and says that around 15% of the universe is made up of pure quant products.
The other important trend is the increased prevalence of style-based products which Hoffman explains as reflecting advances in financial theory, especially among growth-oriented strategies, and the increasing number of products coming out of the US, the home of style-investing: “Style offers a more credible source of differentiation for managers and an excuse to charge higher fees in some cases.”
Russell broadly divides the universe of managers into three styles - growth, value and market-orientated. “Within each style group, we would also define certain sub-styles such as momentum and consistent growth within growth,” explains Hoffman.
Tackling the global universe of equity investment opportunities is as much an exercise in discipline and organisation as it is investment flair. It is not surprising that quantitative techniques have come into the fore and pure quantitative managers are becoming increasingly successful in offering global investment products.
For Russell, quant products these days employ a wider set of aspects, often growth and momentum as well as the traditional value factors. “This makes them more flexible and versatile. It also makes them more attractive to multi-managers as these qualities usually mean they behave differently from more pure style-oriented products,” says Hoffman.
Pure quantitative approaches are however, clearly not utilising all the information that is available in the market place on any particular stock. There is a continuous spectrum of choices on how deeply embedded quantitative techniques are within investment processes.
“Quant models are used at multiple levels by analysts to screen universes and in researching investment frameworks looking at which variables have historically had the highest efficacy in predicting outperformance,” explains Davis at Putnam.
Schroders rebuilt its global equity process in 2002, building on the expertise of their 100 or so regional analysts and fund managers spread in a dozen locations around the world.
The London-based global equity team takes local recommendations and reassesses them in a global
portfolio context. “Most of our equity teams make use of some sort
of a quant model,” explains Price. “We built a team of quant experts who worked with individual teams
to try and produce a quantitative version of their investment process, which acts as an independent
audit rather than a screening process.” Robeco, in contrast, has a far more formal use of quantitative modelling, which accounts for half of its process.
As Glazener notes: “Performance drivers include fundamental and quantitative analysis. The fundamental analysis by the sector specialists, within the global stability team and within the sector teams, aims to select stocks that benefit from long-term fundamental forces.
The quantitative multifactor model was built in close cooperation with the Robeco quantitative research department to take advantage of short-term market behaviour by combining value, momentum,
earnings revisions and management variables into a sector neutral stock ranking. We build portfolios by
combining the results of the fundamental and quantitative analysis to preserve the overall style and risk characteristics of the strategy.”
Narrowing the universe of opportunities in the global context is clearly a key element of any investment process. Having a strong underlying theme to selecting investment opportunities can provide a disciplined selection methodology, if the underlying analysis proves robust.
Russell’s Hoffman, however, sees a “higher degree of difficulty for such strategies since they need to track a wider and more diverse set of data sources and require very skilled analysts to join the dots”.
He adds: “In many cases thematic approaches are used to narrow down the universe to a more manageable number and in such cases it is being used to compensate for a lack of resources and/or alternative - and better - ways to focus research.”
However, even bottom-up research led approaches can have strong themes underlying the stock selection.
At Tradewinds, Iben says of the investment process: “We are bottom-up but we also look at which way the wind is blowing. For example, the middle class throughout the world is growing, and this is having a profound effect on multiple sectors. The emerging middle class is eating more protein, and as a result, agriculture is picking up tremendously.
“The production of corn to support livestock - as well as the growing demand for ethanol - is robust. After 20-30 years of low returns, franchises such as US railroads, tractors and farm equipment, where three suppliers dominate the world, are direct beneficiaries of a rising demand for corn.”
A more formal thematic approach is that of Nordea Investment Management who have had a global thematic process for some years.
“As a growth manager, our challenge has been to stay firm to our core thematic investment belief after several years of value stocks being in favour, and at the same time bringing our highest conviction into a more concentrated portfolio without taking unintentional risks,” says Leon Pedersen, CIO of Nordea Investment Management’s thematic equities product.
Firms with large research teams and regional funds can leverage the expertise within to produce global portfolios with little or no requirement for quantitative stock selection or screening if they can really organise themselves effectively.
However, this is as much an art as a science.
Putnam, according to Davis, used to have a centralised research department five years ago, which was able to provide in-depth research on a select number of large-cap companies.
However, it also led to “a distance between the research analysts and the portfolio management teams
and a lack of flexibility”, which Putnam has corrected by embedding the analysts into the portfolio
management teams, leading to a decentralised structure with US, European, Asia-Pacific and emerging markets teams all divided into regional sector specialists. The exception is the three global sectors of technology, energy and basic materials. Interestingly, the firm also finds healthcare an area that is increasingly a global sector.
Combining the output of large research teams and sector specialists to form an integrated global portfolio usually requires a separate and dedicated global team or individuals able to make objective assessments of the recommendations within the firm rather than management by committee, with no-one willing to admit their mistakes in front of their colleagues.
Threadneedle’s global strategy team, for example, was started three years ago with a team of five based
in London, utilising the research efforts of the regional teams.
TRowe Price, with a large in-house research focused approach to investment, has found success in its global equity product by having a single individual, Rob Gensler, responsible for constructing a global portfolio harnessing the best ideas being produced by the firm’s deep research effort and regional fund managers.
Aberdeen’s Stout says the firm does not use any quant process at all. Instead, the global equities team based in Edinburgh takes all the unconstrained portfolios produced by the regional teams to get 350 names, which are all held in the regional portfolios.
Russell monitors over 200 products in its global equity universe, a number that is constantly growing, according to Hoffman. Choosing managers who will outperform will become a more difficult task ahead though as the perfect storm calms down. The new environment may well be one in which the historical experience of successfully weaththering the storm may prove to be of little relevance.